Midyear Credit Outlook: Slowdown in Europe

Podcast: Thoughts on the Market
Host/Author: Morgan Stanley
Release Date: June 12, 2025

Morgan Stanley's "Thoughts on the Market" podcast features a detailed discussion between Andrew Sheets, Head of Corporate Credit Research, and Aaron Becker, Head of European Credit Strategy. In this episode titled "Midyear Credit Outlook: Slowdown in Europe," the hosts delve into the current state and future prospects of the European credit market, providing valuable insights for investors.

Economic Backdrop in Europe

Aaron Becker begins by outlining the challenging growth expectations for Europe. Despite a strong start to the year, growth is anticipated to slow in the latter half of 2025. He highlights the delayed impact of the German fiscal package announced earlier, which won't significantly boost growth until 2026. Becker states:

"Our economists are expecting growth after a fairly strong start to slow down in the back half of this year." [00:52]

He emphasizes the interconnectedness of European and US economies, noting that nearly a quarter of European companies generate revenues in the US. Additionally, US companies are major players in the European corporate bond markets, holding the largest share of bonds in euro benchmarks. This global perspective is crucial as both Europe and the US are forecasted to experience growth deceleration to below 1% over the next 12 months, contrasting with current credit valuations that imply a growth rate of around 3%.

Credit Spreads Amid Economic Challenges

Andrew Sheets raises an important question about the apparent contradiction between slowing economic growth and tight credit spreads, especially in the investment-grade sector. Despite macroeconomic challenges, Morgan Stanley's forecasts suggest that credit spreads remain relatively narrow.

Aaron Becker explains that several factors contribute to this optimistic outlook:

1. Inflation Deceleration: Unlike the US, Europe is expected to see a more significant reduction in inflation over the coming year.
2. Monetary Policy Easing: The European Central Bank (ECB) and the Bank of England are anticipated to continue easing policies, fostering economic stability and increasing demand for credit products.
3. Attractive Yields: Corporate credit yields in Europe are currently appealing, offering better returns compared to cash alternatives.

"We do think that the ECB and the Bank of England will continue to ease policy that's good for the economy and the eventual rebound." [02:58]

Comparing Current Dynamics to Previous Years

When comparing the current environment to the previous year, Becker notes similarities and differences that influence investor strategies:

• Similarities: The attractiveness of credit yields remains unchanged, offering a carry of approximately 3-3.5% on investment-grade corporate bonds.

  "If you just think about credit as a carry product, you're still getting around between 3, 3.5% on an IG corporate bond today." [04:09]

• Differences: Significant policy shifts have occurred, such as the ECB lowering front-end rates by 200 basis points and a steepening yield curve, which is now at its steepest in two years. This steepening allows investors to benefit from both high carry and roll-down on the yield curve, potentially leading to total returns that surpass those of the past year and approach levels seen during the 2022 LDI crisis.

  "If you aggregate the two figures in terms of your expected total return, credit offers actually total returns much higher than over the past 12 months and closer to where we were in the LDI crisis in 2022." [04:09]

Corporate vs. Government Borrowing

The discussion shifts to the contrasting borrowing trends between European corporations and governments. While governments, particularly Germany and the US, are projected to increase borrowing due to expansive fiscal policies, European companies have remained active in the corporate bond markets.

Becker clarifies that the record issuance of corporate bonds, exemplified by May's highest supply levels, should not be viewed negatively. Instead, it offers new issue premiums and enhances market liquidity, benefiting investors. Importantly, despite the increased gross issuance, net supply is expected to decrease due to a significant rise in bond redemptions (up by nearly 20% compared to the previous year).

"Even though we are projecting this year to be a record year for gross issuance from investment grade companies, we think net supply will be lower year on year as a result of those elevated maturities." [07:37]

This creates a favorable technical backdrop for investors, contrasting sharply with the sovereign market's current challenges.

Investment Strategies in European Credit

Aaron Becker offers strategic recommendations for investors navigating the European credit landscape:

1. Selective Risk Exposure: While opportunities are abundant, investors should be discerning in their risk allocations.

2. Extended Duration: Contrary to consensus, Morgan Stanley advises extending duration further out the yield curve. The current steepening curves offer attractive carry and roll-down benefits.

   "We are quite out of consensus on here at Morgan Stanley is our recommendation in European credit to extend duration further out the curve." [08:05]

3. Valuation and Yield Dynamics: High valuations, limited supply in long-dated bonds, and favorable yield dynamics make corporate bonds a compelling choice.

4. Convexity Benefits: Low cash prices in investment-grade credit enhance risk mitigation, as entering bonds at lower prices can reduce potential losses in adverse credit scenarios.

"Cash prices further out the curve are very low in investment grade credit. That tends to be actually quite attractive because then even if you get the name wrong... your loss given default may be more muted if you entered the bond at a lower cash price." [08:05]

Conclusion

The episode concludes with Aaron Becker emphasizing the multitude of opportunities within the European credit market, provided investors adopt a strategic and selective approach. By leveraging favorable yield curves, understanding the interplay between corporate and government borrowing, and capitalizing on the current economic policies, investors can navigate the challenges and harness the potential of European credit in a slowing growth environment.

Key Takeaways

• Slowing Growth: Both Europe and the US are expected to see growth decelerate below 1% in the next 12 months.
• Attractive Credit Yields: Despite economic challenges, European investment-grade corporate bonds offer appealing yields and potential for higher total returns.
• Increased Corporate Issuance: Record levels of corporate bond issuance enhance market liquidity and provide new investment opportunities.
• Strategic Duration Extension: Extending bond durations can capitalize on steepening yield curves and favorable roll-down dynamics.
• Risk Management: Low cash prices in long-dated bonds offer protective benefits against potential credit defaults.

Investors looking to engage with the European credit market should consider these insights to make informed decisions and optimize their investment strategies in a complex economic landscape.

References

• Timestamped Quotes:
  • [00:52] Aaron Becker on European growth expectations
  • [02:58] Aaron Becker on factors influencing credit spreads
  • [04:09] Comparison of current dynamics to the previous year
  • [07:37] Discussion on net issuance vs. redemption
  • [08:05] Investment strategies and extended duration recommendation

Disclaimer

The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you.